Venture capital (VC) is the process of investing private equity in companies, typically in early stages of development, that are believed to offer significant potential to grow substantially and reward investors accordingly. The objective of VC is to generate high rates of return over long periods of time. VC offers institutional investors and high-net-worth individuals high returns (historically better than stocks) and strong diversification benefits from very low correlations with other asset classes. The major negatives of investing in VC are long time frames, lack of liquidity, and high management fees.
VC firms typically manage multiple funds formed over intervals of several years. Funds are illiquid but as companies in the portfolio go public or are sold, the investors realize their returns. Funds typically consist of limited partnerships invested in a number of companies. A general rule for the breakdown of returns among VC company investments is 40% will be complete losses, 30% will be “living dead,” with the remaining 30% generating substantial returns on the original investment. The big winners yield 10 or more times the original investment.
Should a Business Look for Venture Capital? How Do We Locate it?
An entrepreneur should consider whether his or her business fits the criteria used by most venture capitalists, also known as VC’s. Venture capitalists usually wish to invest a large amount of money, on the order of several million dollars. Some VC’s are willing to invest a smaller amount of seed money in a start-up. Venture capitalists generally look for a business that can grow quickly and generate an annual return over 40%. Investors in VC’s usually expect an annual compounded rate of return of at least 25%.
Venture capitalists tend to focus on certain industries. Most commonly VC’s focus on information technology like computer hardware, software, scientific instruments, telecommunications, multimedia and the Internet. The second most common focus is on life science companies that develop products such as biotechnology, medical devices, diagnostic equipment, and therapeutics. However, venture capitalists are primarily focused on making a high rate of returns on their investments so they will invest in other companies that have such potential.
Venture capital funding has both benefits and drawbacks. They tend to have access to large amounts of capital and can provide expertise in management, marketing and personnel. However, they tend to demand more control over the business and usually require a larger percentage of the equity than other financing sources.
Venture Capitalists receive dozens of unsolicited business plans every week. Thus, sending an unsolicited business plan to a VC will most likely lead to nowhere.
Getting someone who personally knows a venture capitalist to arrange an introduction is the best way to get his or her attention. A friend of an entrepreneur who has obtained venture capital financing can provide an introduction. Additionally, people at universities, government research laboratories, or entities that license technology to venture-backed companies can also have connections. Accountants and bankers who work with VC’s, money managers at pension funds, insurance companies, universities, and other institutions that invest in VC’s are other good sources of contacts.
One of the best ways to find venture capital is to retain an attorney who works with venture capital firms as a business attorney. Fewer than a dozen firms nationwide specialize in representing venture financed companies although many lawyers may have done a venture capital deal. Most of the law firms that specialize in representing these start-up companies are located in Northern California’s Silicon Valley.
An entrepreneur should find out what venture funds the a law firm has formed, how many and which venture firms a law firm has represented, and what companies it has represented when choosing a law firm. Experienced law firms will have this information readily available.
A law firm that specializes in this area will also have lawyers with enough experience to advise and inform the entrepreneur on what to expect from and how to deal with the venture capitalists. Venture capitalists tend to have their own set of rules and having an attorney familiar with those rules is helpful.
Since this industry tends to resemble a small club, an entrepreneur’s lawyer may have or is currently representing the venture capitalist as well. Legal ethics require an attorney to disclose such potential conflicts of interest to both parties in a transaction and get consent from them. An entrepreneur should inquire about the potential for any such present or prior relationship with any VC that his attorney introduces to him.
Attorneys who specialize in this field should work with a large number of venture capitalists. Thus, they should be able to introduce an entrepreneur to those venture capitalists that would be the best fit for the entrepreneur in terms of potential interest, industry focus and stage of the start-up. Venture capitalists tend to prefer investing at particular stages in a company’s development be it at the very beginning (“seed”), when a product or service is in beta testing (“early stage”), when the product or service is fully developed and generating revenue (“later stage”), or in the financing round just before the initial public offering (“mezzanine”).
Seeking Venture Capital: Range of investment strategies
Traditional venture capital firms manage funds that are typically in the hundreds of millions of dollars. Besides differing by size, different funds have different orientations. Some funds specialize in seed stage investments, while others might only do advanced stage or bridge financing. Others might concentrate their efforts on a specific industry or class of companies; specialty areas may be Internet ventures only, or retail; others may prefer manufacturing or just computer software. Some large funds run what is termed a balanced fund which invests over a broad spectrum of industries and company development stages.
For all funds, their prime criteria are solid, experienced management teams who have identified a clear market niche with a large growth potential and the possibility of developing a hundred million dollar plus annual company revenue.
Frequently, partners in the fund will have prior experience and current knowledge in the areas in which they invest. This results in their being better equipped to take an active part in guiding the companies in which they invest, in such areas as planning, marketing, developing supplier connections, finding new personnel, and bringing in additional financing sources.
Methods of operation
Another item in common for both private and corporate funds is the minimum and maximum amounts they’re willing to invest. Their line of reasoning regarding the minimum is that it costs them just as much time and money for due diligence in making a $10,000 investment as it does for $10,000,000. The maximum amount is often set by policy; such as any single investment is limited to x percent of their total funds. However, all funds are capable of putting together syndicates with other funds to provide almost unlimited financing for the right entrepreneurial projects.
Be selective in applying
Make sure that the firms that you approach are interested in your type of project, that is, your industry, stage of development, etc. Also, many funds prefer only projects located within two or three hundred miles or two or three hours from their headquarters. Some firms operate incubators, making their coverage area even smaller.
If you identify a firm that likes your industry, but you’re located outside their preferred geographical investment area, ask if they know of a firm in your area. Many funds participate in investments with other firms if there is a “lead” investor who will agree to monitor a portfolio company.
When a fund indicates that it has a preference for a particular industry, it usually means that one or more of the general partners has some background in that industry. This can be especially helpful to the entrepreneurial team because they don’t have to spend a lot of time getting the venture capitalists up to speed on industry knowledge. It’s also helpful because the venture capitalist can get quick answers to due diligence questions, and after making an investment is usually able to bring a lot of their industry contacts into the deal to help it grow and sometimes even staff the portfolio company
Wishing you success,
John B. Vinturella, Ph.D.
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